U.S. Third-Quarter Growth Forecast Raised; Fed’s September Decision Still Depends on Inflation

Overview

This report assesses the outlook for U.S. growth, employment, inflation, and Fed policy, and provides thematic analysis of the rebound in manufacturing ISM, the impact of artificial intelligence on the labor income share, and the divergence between core CPI and core PCE inflation. The report argues that the U.S. economy remains in relatively solid condition, with business surveys and potential inventory rebuilding supporting a rebound in third-quarter growth. However, signals within the employment report are mixed, consumption may weaken, and services prices remain elevated, keeping Fed decisions highly dependent on incoming data.

Core views

First, the decline in the July unemployment rate indicates that the labor market remains broadly healthy, but the drop in nonfarm payrolls, continued decline in labor force participation, and slower wage growth suggest that labor demand is not overheated. Second, PMI and ISM surveys show accelerating manufacturing and services activity, supporting an increase in the third-quarter real GDP growth forecast to 2.5%, but the historical relationship between manufacturing ISM and GDP has weakened, so a jump in the index should not be equated with a sharp economic acceleration. Third, the key variable for the Fed’s September meeting is the forthcoming inflation data; if core goods prices continue to come in below expectations, this would weaken the view that inflation remains sticky. Fourth, the labor income share has fallen to a historical low, and capital substitution driven by artificial intelligence, together with stronger corporate pricing power, may allow the capital income share to keep rising. Fifth, the unusually negative gap between core CPI and core PCE is expected to narrow, but it is unlikely to return to the norm of the past decade in the short term.

Analysis framework

The report combines high-frequency indicators such as employment, wages, labor force participation, PMI, ISM, productivity, unit labor costs, CPI, PCE, and retail sales, and uses historical regressions to compare the explanatory power of business surveys for GDP. In the income distribution section, it decomposes the decline in the labor income share into within-industry changes and between-industry reallocation, and cross-checks the decline using profit margins and returns on capital. In the inflation section, it analyzes the CPI-PCE gap from the perspectives of weights, data sources, coverage, and substitution effects.

Methodology notes

• Macro ForecastingIntegrated Assessment of High-Frequency Indicators

  Multi-indicator cross-validation of growth and policy

  Combines labor market, business survey, consumption, and inflation indicators to assess economic momentum, and adjusts quarterly GDP and policy probabilities based on new information.

• Econometric AnalysisHistorical Regression and Structural Break Tests

  Predictive power of business surveys for real GDP growth

  Compares the relationships between manufacturing ISM, services ISM, manufacturing PMI, and annualized quarter-on-quarter real GDP growth, while identifying structural changes around 1985; the results show that the explanatory power of manufacturing ISM has declined over time.

• Structural AnalysisShare Change Decomposition

  Within-industry and between-industry changes in the labor income share

  Decomposes the decline in the overall labor income share into declines within industries and industrial structure reallocation to determine whether the change is driven by the expansion of industries with low labor shares.

• Scenario AnalysisInflation and Fed Reaction Function

  Impact of different core inflation paths on the September policy decision

  Uses core CPI of around 0.22% and repeated readings close to 0.3% as different scenarios to assess the likelihood of the Fed maintaining policy or raising rates.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• U.S. Treasuries

  Primarily affected by Fed policy and the inflation path

  Strengths

  Moderate wage growth and unit labor costs, along with an employment report that does not show an overheated economy, help limit upward pressure on yields.

  Weaknesses

  Improved business surveys, an upwardly revised GDP forecast, and elevated services prices may still reinforce tightening expectations.

  Comparison

  The front end is more sensitive to September policy probabilities, while the long end is also affected by growth, inflation, and fiscal borrowing needs.

  Risks

  Core CPI repeatedly close to 0.3%, a rebound in core goods prices, or uncertainty over Fed governance could trigger higher yields.

• U.S. Equities

  Growth resilience and changes in profit distribution provide support, while rising rates constrain valuations

  Strengths

  The upward revision to third-quarter growth forecasts, improving manufacturing and services activity, and a higher capital income share are all favorable for corporate earnings.

  Weaknesses

  Weak retail sales and job growth may weigh on consumption-related revenues, while sticky inflation could prolong a high-rate environment.

  Comparison

  Cyclical sectors are more supported by the growth rebound, while high-valuation growth sectors are more sensitive to changes in real rates.

  Risks

  Failure of business surveys to translate into actual growth, weaker consumer spending, or renewed Fed rate hikes could trigger valuation adjustments.

• U.S. Dollar

  Driven jointly by relative U.S. growth and policy rate differentials

  Strengths

  An upward revision to U.S. growth forecasts and the risk of potential rate hikes could widen the relative rate differential advantage.

  Weaknesses

  If inflation is moderate and employment continues to slow, expectations for policy tightening may decline.

  Comparison

  The dollar’s direction depends on U.S. data relative to other economies, rather than a single U.S. indicator.

  Risks

  Inflation data that deviate significantly from expectations or disputes over Fed governance could increase exchange rate volatility.

• U.S. Manufacturing and Cyclical Industries

  Driven by the rebound in manufacturing ISM and a potential inventory rebuilding cycle

  Strengths

  Manufacturing ISM rose to 55.6, with broad improvements in new orders and production subcomponents.

  Weaknesses

  The historical link between manufacturing ISM and actual GDP has weakened, and national accounts inventory data remain inconsistent with survey signals.

  Comparison

  Within the shared sample, services ISM and manufacturing PMI fit GDP better than manufacturing ISM.

  Risks

  Tariffs, energy prices, divergence between surveys and hard data, and unrealized inventory rebuilding could weaken the activity rebound.

• AI-Related Capital and Companies

  Artificial intelligence may increase capital substitution capacity, profit margins, and the capital income share

  Strengths

  Most related macro models expect AI expansion to reduce the labor income share, and companies may also use personalized pricing to raise markups.

  Weaknesses

  Artificial intelligence has not yet shown a stable and significant contribution in aggregate productivity data.

  Comparison

  Capital owners may obtain a higher income share, while workers’ bargaining power and income share come under pressure.

  Risks

  Productivity gains materializing more slowly than expected, regulatory intervention, widening income inequality, and the resulting policy response.

Key data

• July unemployment rate4.1%Down 0.1 percentage point from 4.2% in June, marking a low since early 2025.
• July nonfarm payroll change-23,000After downward revisions, average job growth over the past three months was only about 20,000.
• July average hourly earningsUp 0.05% month-on-monthThe annualized growth rate over the past three months fell to 2.3%, within the pre-pandemic range.
• Third-quarter real GDP forecast2.5% annualized quarter-on-quarter rateRaised from the previous 1.75%, mainly based on improved business surveys and expectations for inventory rebuilding.
• July services PMI business activity index54.6Largely reversed the weakness in the first half of 2026; the survey provider estimates this corresponds to about 2.3% GDP growth.
• July manufacturing ISM55.6A significant rebound from 47.9 in December 2025; the model corresponds to about 2.3% GDP growth in the third quarter.
• Second-quarter productivity growth1.4% annualized quarter-on-quarter rateAbove the 0.5% forecast; up 2.2% year-on-year, but cumulative momentum over the last three quarters has been weak.
• Unit labor costsUp 1.4% over the past four quartersIndicates that the labor market is not currently generating obvious cost-push inflation pressure.
• July core CPI forecastUp 0.22% month-on-monthA single reading at this level is expected to be insufficient to trigger a September rate hike, but repeated readings close to 0.3% could raise the probability of a rate hike.
• July retail sales forecastDown 0.4% month-on-monthControl-group sales are expected to fall 0.3%, potentially corresponding to flat real consumer spending month-on-month in July.
• Nonfarm business sector labor income share53.7%Hit a record low in the first quarter of 2026, about 3 percentage points below the year before the pandemic.
• Change in private-sector labor income shareDown 1.7 percentage pointsFell from an average of 49.6% in 2018–2019 to an average of 47.9% in 2023–2024; 74% of the decline came from within-industry decreases.
• Core CPI and core PCE gap-0.7 percentage pointIn June 2026, core CPI was up 2.6% year-on-year and core PCE was up 3.3%; the gap is expected to narrow but not quickly return to historical norms.

Impact & implications

The upward revision to the growth forecast and improvement in business surveys support risk assets and cyclical sectors, but weaker employment and retail sales limit room for excessive optimism. If core inflation maintains a monthly pace of about 0.2%, pressure for a Fed rate hike in September may remain contained, supporting interest rate assets. If services prices remain at cyclical highs, core goods prices rebound, and core inflation moves repeatedly close to 0.3%, short-end rates and the dollar may rise, while equity valuations could face pressure. A continued decline in the labor income share could raise corporate profit margins and returns on capital, but it would also widen income distribution imbalances, increase excess savings, and may require greater borrowing by the public sector or external sector.

Risks

• Job growth continues to weaken, and declining labor force participation masks actual labor market weakness.
• Services prices remain at cyclical highs, and a rebound in core goods prices causes inflation to reaccelerate.
• Business surveys continue to diverge from hard data on actual output, inventories, and consumption.
• July retail sales are weaker than expected, and real consumption momentum declines significantly.
• Fed governance issues and legal disputes related to Governor Cook increase uncertainty around the September meeting.
• Artificial intelligence fails to improve aggregate productivity in a timely manner, while further depressing the labor income share and widening inequality.
• Excess savings resulting from a rising capital income share require higher borrowing by the government or external sector to absorb.

What to watch

• July headline CPI and core CPI, especially core goods and non-housing services prices.
• Subsequent inflation reports before the September FOMC meeting.
• July retail sales and control-group sales, assessed together with the timing shift in June promotions to evaluate consumption trends.
• Nonfarm payroll revisions, labor force participation, the employment-population ratio, and average hourly earnings.
• Whether manufacturing ISM, services ISM, and manufacturing PMI can translate into actual GDP and inventory growth.
• Whether productivity growth can reaccelerate, and whether artificial intelligence begins to generate meaningful aggregate effects.
• The pace of convergence in the core CPI-core PCE gap and the September PCE methodology revisions.
• Legal developments in the Fed Governor Cook matter and whether Governor Cook participates in the September meeting.